The Investment Strategy Tester: Part One — Low Stock Allocations Can Be Riskier Than High Stock Allocations

The most important factor affecting an investor’s results is his stock allocation. So argues the conventional investing wisdom of today, a wisdom popularized during the Buy-and-Hold Era from a wide array of financial publications.

I don’t subscribe to the Buy-and-Hold Model for understanding how stock investing works. I believe that this model, developed during a time when belief in the Efficient Market Theory was strong, is hopelessly flawed, and favor a model that I call “The Valuation-Informed Indexing Model.” The difference is that, while the Buy-and-Hold Model posits that there is no need for an investor to change his stock allocation in response to big changes in valuations, the Valuation-Informed Indexing Model posits that at least occasional allocation shifts are critical to long-term success. Investors who stick with the same stock allocation at all times are permitting their risk profiles to go wildly out of whack when stock prices go to levels far higher than the levels at which they determined that that stock allocation was appropriate.

A Valuation-Informed Indexer would agree that the most important decision an investor makes is the one he makes regarding his stock allocation. But a Valuation-Informed Indexer would add that it is impossible for any one stock allocation always to be right for any investor. The only way to choose your stock allocation effectively is to take into consideration the effect of valuations on long-term returns when making the choice and to make fresh choices as needed to keep your risk profile roughly constant. The best stock allocation is a stock allocation that varies with changes in stock valuations (heading downward when valuations rise and heading upward when valuations drop).

The Strategy Tester is an investment strategy calculator that permits users to create up to four strategies and compare how they perform in 1,000 30-year return sequences. The return sequences are generally random but not entirely so; statistical filters are applied to insure that they play out in a manner similar to how we have seen 30-year sequences play out throughout the historical record. That is, a Reversion to the Mean phenomenon works to pull valuations down when they get absurdly high and to pull valuations up when they get absurdly low.

The results of each strategy tested are reported in the form of color bars comprised of four colors: (1) green; (2) blue; (3) yellow; and (4) red. Each of the colors points to 25 percent of the results obtained from the 1,000 tests performed. Thus, the red color bar points to the worst possible results that could turn up for the indicated strategy, assuming that stocks perform in the future at least somewhat as they always have in the past. The green color bar, in contrast, points to the best results possible. The point at which the yellow color bar meets the blue color bar is the midpoint of all possible return sequences; the investor choosing that strategy knows at the outset of the 30-year time-period that there is a 50 percent chance that his real-world results will be better than the result shown at the midpoint and a 50 percent chance that his real-world result will be worse than the result shown at the midpoint. Results are shown at five years out, ten years out, fifteen years out, twenty years out, twenty-five years out and thirty years out.

The Strategy Tester shows that it is valuations that are the single most important factor bearing on long-term investing success. Investors willing to change their allocations in response to big price swings earn higher returns at less risk than do investors who insist on sticking with a single stock allocation at all valuation levels.

Graphic #1 shows that high stock allocations generally yield better results than low stock allocations. All of the results shown in Graphic #1 presume a starting-point P/E10 level of 14, the fair-value P/E10 level (P/E10 is the price of the S&P Index over the average of the last 10 years of its earnings). The four stock allocations examined are: (1) 20 percent stocks; (2) 50 percent stocks; (3) 80 percent stocks; and (4) 100 percent stocks.

(click on image to view a larger version)

The results for the 20 percent stock allocation are horrible. It’s not just that investors going with a low stock allocation give up the possibility of earning appealing returns by doing so. The low end of the red color bar reveals to investors the worst-case scenario for the strategy being tested. From Year 20 forward, the 20-percent stock allocation yields the lowest red color bar. The suggestion is that the risk associated with the 20-percent stocks portfolio is greater than the risk associated with the other portfolios. It’s not that the higher-stock-allocation portfolios may do better and may do worse. In the long run, there is no realistic scenario in which the higher-stock-allocation portfolios can generate results as poor as those that may well be generated by the 20-percent-stocks portfolio. Going with a low stock allocation is risky, according to The Investment Strategy Tester.

The other side of the story is that going with what would generally be viewed as an insanely high stock allocation does not appear to carry all that much risk. At 10 years out and at 15 years out, the 100-percent-stocks portfolio shows both higher possible returns and worse worst-case scenarios; that’s a finding consistent with the conventional thinking that higher stock allocations provide potentially higher returns at the cost of added risk. However, this is no longer the case from Year 20 forward. At Year 30, the 100-percent-stocks portfolio offers significantly greater upside combined with a worst-case-scenario no worse than that offered by any of the other portfolios and better than the 20-percent and 50-percent portfolios. Stocks are pretty darn appealing when selling at reasonable prices!